Disinflation and the Dollar

Find out what's in store for the greenback and the best way to play the impending move.
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In this season of giving thanks, I can count among my blessings the many readers who have shared their thoughts, comments and concerns about my columns. One observation I've made is that whenever readers ask when something is likely to occur, the opposite is more likely to materialize. We all wanted to know where the top was in 1999, and everyone tried to call the bottom in 2001. That was a good use of mental capital, wasn't it?

More recently, questions about deflation and the dollar's strength have been piling up in my inbox, so I thought it might be useful to tackle these issues simultaneously from the perspective of the ongoing debacle in Japan.

An Unexpected Twist

The notion that a currency's strength somehow measures global approval or reflects an economy's strength has only a mixed basis in reality, but like most financial urban legends, it dies hard.

The Japanese economy has been in trouble since its combined equity and real estate bubble burst at the end of 1989, and nominal interest rates in Japan have fallen close to 0%. However, the yen, noted in the chart below as JPY, has strengthened the most when bank lending has weakened the most.

Yen Strengthened as Bank Lending Stagnated

Source: Bloomberg

The reasons behind this inverse relationship are not that obscure. Bank lending in the U.S. is a lagging indicator of economic activity; it tends to peak after an expansion peaks as credit lines are drawn down in the face of declining profits to finance operations. Bank lending remains weak after an economic trough is reached, as borrowers are still reluctant to take on new financial risks.

In both Japan and the European Union, bank lending is more important than corporate bond and equity markets, which means bank lending is more of a coincident economic indicator in these economies. As business activity in Japan slows, Japanese exporters and creditors repatriate funds in lieu of bank borrowing, and this creates a high demand for the yen.

More important, however, is the impact of lower lending on total money supply. Even as the Bank of Japan has driven nominal rates lower and has engaged in quantitative easing policies, total credit expansion has been lackluster. Bank balance sheets are still staggering under the weight of nonperforming loans, and banks prefer to lend surplus funds in the government bond market rather than extend new loans. Corporate borrowers, awash in surplus capacity, have little need to borrow. The weak bank loan market refuses to transmit the central bank's policies into the total credit market, and the result is a persistent deflation. If a currency is expected to become more valuable over time as a function of negative inflation, it rises in the foreign-exchange market. This is the cycle noted in the chart above.

What About the U.S.?

Now, let's construct a similar picture for the American economy. Because many American corporate borrowers use the commercial paper market instead of the bank loan market, we'll use the Conference Board's index of bank loans plus commercial paper issued by nonfinancial corporations. The trade-weighted dollar index, or DXY, will be used as a measure of the dollar's strength.

Can It Happen Here?

Source: Bloomberg

As expected, credit demand fell during the recession of the early 1990s. While credit demand turned higher in February 1992, the DXY remained under pressure until October 1992. The DXY then weakened in the face of growing credit demands until August 1995. But ever since, the DXY has continued to move higher, regardless of a credit demand cycle, as global investors sought it both as a refuge and as the currency representing the highest-returning assets.

The recent plunge in credit demand, which began in September 2000, is the most precipitous in the history of the Conference Board data. It has continued in the face of 10

Federal Reserve

rate cuts and stands as testimony to both the Fed's mismanagement of monetary policy in 2000 and early 2001 as well as the severity of the present recession.

What's in store for the greenback? Credit demand is a lagging indicator of economic activity, and plummeting credit demands will offset central bank policies here as they did in Japan. Therefore, we should expect continuing negative inflation and thus a strengthening dollar for several months into a new economic expansion, whenever that happens. Once an economic recovery is in place, rising credit demands will lead to an abrupt expansion of total credit within the banking system. That will send out reinflation signals and produce a weakening -- perhaps a catastrophically weakening -- dollar.

What's the best way to play such an impending move? First, make sure the economy is strengthening. Next, look to achieve non-dollar diversification with value stocks in East Asian and European markets. Finally, watch out for a prolonged bear market in U.S. bonds.

Howard L. Simons is senior vice president of product research at Nasdaq Liffe Markets, a professor of finance at the Illinois Institute of Technology, a trading consultant and the author of

The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he invites you to send your feedback to

Howard Simons.

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